Defensive Inflation Plays

While the U.S. economy is recovering, fueled by the Fed’s monetary expansion, to most, high inflation seems a long way off. But some smart folk – such as U. S. Bank Wealth Management’s chief executive, Mark Jordahl – are predicting a serious discussion on inflationary pressures by year’s end and rates rising in 2014, all in a pre-emptive effort to smother inflationary embers before a wildfire takes hold.

Time will tell whether the Fed timed things right; the track record of central banks, historically, does not breed confidence. But there is no reason to sit inert in a depressive funk. U.S. investors can prepare themselves in case the Fed loses its grip and prices suddenly skyrocket, by studying the lessons learned by other investors who have lived with and invested in high inflation countries like Argentina, Russia, and Mexico.

In periods of high inflation, local currencies devalue, meaning that while the real value of assets may not change meaningfully, the nominal price of assets increases dramatically. This leads to rapid erosion in the value of most financial assets, and a corresponding increase in the real value of financial liabilities, such as mortgages, since the amount that must be repaid is fixed in nominal terms.

Eric Fine, the portfolio manager for the Unconstrained Emerging Markets Bond Fund (EMBAX) at Van Eck Global, experienced inflation firsthand, as a young entrepreneur in Russia in the early 1990s. The telecoms company he founded couldn’t always pay employees or vendors in rubles because of inflation. Dollars were expensive; he used to pay smaller vendors – office movers, for instance – in bottles of vodka. The value of the potato spirits was more stable than that of the ruble. Fine today continues to think about how to make money from inflation.

For bond investors, he recommends they “own inflation-linked securities in countries with a relatively high degree of rule of law, where they’re not going to lie to you about inflation.” Latvia and Ireland are two such nations. “Greece, we’re going to see,” he says.

Furthermore, “you want to have currency exposure in countries that will defend against inflation.” Mexico and Chile are examples of central banks that pursue price stability as a goal.

The idea behind this strategy is that the currencies of countries committed to keeping their prices level will benefit if inflation hits the U.S. and the dollar loses value. As the foreign debt is repaid, the investor will earn more dollars for each Mexican peso exchanged back into U.S. currency, hedging against the devaluation of the U.S. dollar.

“The experience of investors in emerging markets is that all debt undertaken to invest in a country should be in local currency,” says Jordi Canals, dean of the University of Navarra’s IESE business school, in Barcelona.

Hard assets – real estate, factories, forests – are where emerging-markets investors have historically made money in inflation-hit countries. That’s because although real estate may fall in value, it’s likely to fall less than other assets, says Walter Zimmermann, vice president and chief technical analyst at brokerage United ICAP in Jersey City, N.J.

“Traditionally, in an inflationary environment, you want to own real estate and you want to take on debt to buy things sooner and more frequently,” Zimmermann says. “The biggest debtor is the biggest winner. Borrow with more expensive dollars and pay back with cheaper dollars.”

Of course, after the pain of the last recession, most investors are wary of once again becoming too leveraged. Furthermore, tight credit in the post-crisis U.S. has made real estate a far more difficult play. But investors who can borrow money to buy property might want to try this classic inflation hedge. U.S. Bank’s Jordahl says that’s exactly what wealthy families are doing today: leveraging up as the rest of the world deleverages.

But caution. Some analysts warn that the modest rate of inflation the U.S. is seeing now is a result of an economy that’s doggie-paddling, not expanding. That’s different from the situation that led to hyperinflation in countries like Argentina and Brazil, when a growing economy spurred inflation.

In an environment like this, textbook hedges like buying real estate or gold may not work, says Larry Young, a managing director at restructuring firm AlixPartners and who has turned around businesses in several inflation-hit countries such as Mexico.

Sinking cash into a real asset like a large piece of land is a smart move – if you can sell it in a few years for more money. “The problem is, if your economy isn’t growing, that asset might be worth more in nominal terms because of inflation, but if nobody can buy it, you won’t be able to sell it,” Young says.

With real estate again showing signs of life, however, that risk seems to be abating. But one inflation-fighting strategy that hasn’t worked recently: owning gold, which has historically held or increased its value in periods of anticipated or actual inflation. “You would never know that there are inflationary pressures by looking at the price action in gold recently,” says Zimmerman. But perhaps gold isn’t happening now because the price of gold has already appreciated dramatically since the onset of the financial crisis. The S&P’s gold ETF (GLD) is up 60%, to $137, since Lehman’s brankruptcy in September, 2008.

Fed Chairman Ben Bernanke is famously a student of the Great Depression; his response to the 2008 financial crisis was hyper-focused on monetary policy rather than fiscal policy (which was, in any event, out of his control.) Many analysts now worry that the Fed may not be able to bring stable growth to the U.S. economy absent continued monetary easing – especially now that both the European Central Bank and the Bank of Japan have followed the Fed’s lead in expanding their own money supplies.

William Rhodes, a longtime international financier whose recent book, Banker to the World, details his career negotiating debt settlements with crisis-hit countries like Brazil and Argentina, says the question of when and how the Fed will stop pumping money into the economy is crucial to inflation expectations.

“If you don’t do it in an organized, proper fashion, what will happen is, it can set up another bubble,” Rhodes says. “If you wait too long to exit or unwind, you start feeding the fires of inflation.”

About Penta

Written with Barron’s wit and often contrarian perspective, Penta provides the affluent with advice on how to navigate the world of wealth management, how to make savvy acquisitions ranging from vintage watches to second homes, and how to smartly manage family dynamics.

Richard C. Morais, Penta’s editor, was Forbes magazine’s longest serving foreign correspondent, has won multiple Business Journalist Of The Year Awards, and is the author of two novels: The Hundred-Foot Journey and Buddhaland, Brooklyn. Robert Milburn is Penta’s reporter, both online and for the quarterly magazine. He reviews everything from family office regulations to obscure jazz recordings.